How Small Companies Suffer When Investors Vote in Lockstep With Proxy Advisors

Delegating shareholder votes to ISS and Glass Lewis is cost-effective, but it often undermines smaller companies’ diversity goals.

Illustration by II

Illustration by II

Smaller companies have a steep hill to climb when it comes to recruiting more women and minorities to their boards, but the nation’s two largest proxy advisors can make it even harder.

The problem arises as a result of institutional investors delegating their voting rights to Institutional Shareholder Services and Glass Lewis, which is common practice. ISS and Glass Lewis research proxy proposals and issue voting recommendations on thousands of companies.

While the two advisors have developed a set of standards to provide voting proposals on a wide range of corporate governance issues, such as board composition and capital structures, they are impeding — even if unintentionally — much-needed diversity progress at smaller public companies, according to Dallas-based investment manager Ranger Investments. The asset manager is pushing shareholders of smaller companies to think twice before blindly following the proxy advisors’ recommendations.

Here’s how it works: During the proxying voting process, shareholders can vote “For,” “Against,” or “Withhold” on their ballots, the last two of which signal their passive, but negative, views about certain corporate decisions. ISS and Glass Lewis often recommend that investors vote “Withhold” or “Against” all board members standing for the nominating and governance committees because of broader issues. For example, directors could be voted down for their company’s adoption of the classified board structure, which is often considered a less progressive governance approach because it allows more senior members to serve longer terms. In such cases, proxy advisors would recommend voting “Withhold” or “Against” directors standing for re-election, regardless of their credentials. As more companies bring women and people of color onto the nominating and governance committees to promote overall board diversity, removing them over such technicalities can significantly set back the company’s progress, said Andrew Hill, president and portfolio manager at Ranger Investments.

And the challenge is especially acute for small companies because proxy advisors “tend to benchmark smaller-cap and micro-cap companies based on their large-cap peers,” Hill said. A small-cap consumer company could be held to the same standards as Procter & Gamble because the advisors can’t customize their proxy decision framework for the thousands of companies they oversee. But unlike their large company peers, which have established pipeline diversity programs and inclusion events, smaller firms have fewer resources to recruit female and minority directors. As a result, they suffer more when their diverse board member picks are voted down. In fact, the removal of a diverse board member can sometimes hurt the company more than the broader corporate governance issue that led to the “Against” or “Withhold” vote in the first place, according to Hill.

Given the duopoly of ISS and Glass Lewis in the market, it is almost impossible for them to customize proxy voting proposals for firms of different sizes. Controlling at least 90 percent of the market, the two “have assumed outsize influence over corporate voting matters,” wrote Paul Rose, a professor at the Moritz College of Law at Ohio State University, in a Manhattan Institute paper published last year. Rose found that 114 institutional investors with $5 trillion in collective assets under management have opted for “robovoting,” meaning they mechanically vote in lockstep with their proxy advisors’ recommendations.

ISS argues that its power is overstated. Marc Goldstein, head of U.S. research at ISS, told Institutional Investor that proxy advisors have limited power over shareholders’ decisions, especially when it comes to voting down diverse members of the board. “Regardless of the ISS recommendations, some shareholders will be reluctant to vote against the only women” or person of color, he said. And even if a diverse member of the board does not get the majority vote, he or she does not get directly removed from the board in all U.S. states, except California. Instead, the board reviews the director’s resignation letter before making the final decision. “Spoiler: the board usually doesn’t [accept the resignation],” Goldstein said.

Fionna Ross, senior ESG analyst at U.K.-based asset manager abrdn, said although the company relies on ISS for some voting decisions, it doesn’t mechanically follow the proxy advisor on every vote. Abrdn has an in-house proxy team that prioritizes board diversity in the investment process, Ross said, adding that its decision framework does vary by the company’s size. “For large-cap companies that we invest in, we push to see at least a 25 percent female representation on the board,” she said. “For smaller companies, we want at least one female representative on the board.” Abrdn won’t follow the proposals from ISS if they are at odds with its own framework, according to Ross.

Courteney Keatinge, senior director of environmental, social, and governance research at Glass Lewis, is confident that companies will ratchet up their efforts to replace any diverse candidates who were voted down with another person of color or woman. “In the last couple of years, every company that we’ve talked to, regardless of their profile, wants to talk about how they are encouraging diversity on the board,” Keatinge said. “I have not heard many excuses from companies as far as diversity is concerned.”

A larger problem may be an industry-wide reluctance to widen the field of possible executives for boards. Goldstein said many companies will only “go down one level” below the C-suite when they need to replace the current crop of directors.

“A lot of terrific candidates have not been promoted up to the C-Suite yet,” Goldstein said. To promote a diverse and inclusive work environment, companies need to stop overlooking mid-level talent, he concluded.